What is Blockchain Insurance in DeFi?

Introduction

Insurance companies exist to shield their clients from unforeseen incidents.

They profit from the regular payments (premiums) they get from clients, promising to cover any losses if a rare event occurs. Simply put, the insurance model relies on collecting more in premiums than what it pays out in claims.

This long-standing model is on the brink of a major change with blockchain technology and the rise of smart contracts and oracles.

A blockchain insurance contract works on a pre-set agreement in a smart contract. If the conditions outlined in the contract are met, the contract executes automatically, and the agreed sum is paid out. All this happens without the need for an intermediary, such as an insurance company. Smart contracts receive the information they need to make a decision through Oracle technology.

Even though this technology is fascinating, widespread adoption in the traditional insurance industry could take some time. However, DeFi (decentralized finance) space is already harnessing insurance protocols, and that's the primary focus of this article.

Understanding DeFi Insurance

Different from fiat currencies, cryptocurrencies are not backed by any government. This absence of government backing means that crypto assets aren't protected against potential mishaps, such as hacks or unexpected code flaws (rug pulls).

If a bank goes bankrupt in the US, for example, the FDIC can cover clients' losses up to U$250,000. In the crypto world, if a DeFi protocol gets hacked, there's no safety net to recover the lost funds unless you're protected by a blockchain-based insurance contract.

Some crypto exchanges, like Binance and Coinbase, offer internal policies to protect clients’ funds, but if these exchanges go bankrupt, clients don't have the same governmental protection they'd have with banks, meaning that people are still risking their assets by keeping them in a centralized exchange.

Let's now take a look at some of the types of insurance and the protocols that offer these products:

• De-pegging Insurance

This type of insurance became famous after the Terra Luna crash. It covers situations where the value of a "stablecoin" (like Terra's UST token) suddenly crashes, unable to maintain the value of U$ 1.00. If a de-pegging event occurs and you're covered by insurance, you can recover all or most of your losses, depending on the contract terms.

This insurance is very popular for stablecoins, but it may also be used for other tokens with the risk of de-pegging, like synthetic tokens.

• Smart Contract Vulnerability Insurance

This type of coverage is in high demand among investors who interact with DeFi protocols frequently. It insures against hacks, exploits, and other attacks on a protocol where the user had assets invested.

• Custodian Coverage

This insurance covers the losses an investor may suffer by entrusting their assets to a custodian, such as a centralized exchange, wallet, or even a traditional bank.

These 3 types of insurance are the most demanded by the crypto community. The main protocols that provide insurance, according to DeFi Llama by TVL are Nexus Mutual, Unslashed, and InsurAce.

Each of these protocols is decentralized, relying on Liquidity Providers (LPs) to provide the necessary capital to cover the clients' needs. If you're looking to earn interest on your assets, you can deposit them in a pool created by any of these protocols.

By becoming an LP, you’re interacting with a decentralized pool, which leaves you exposed to some risks, so we recommend you read all of the information on the protocol before doing so!

Remembering Past Disasters

The crypto market is relatively young compared to other financial markets. Probably because of that, it has seen a fair share of catastrophes that could have been avoided if the investors had bought insurance.

It’s also good to mention that many insurance protocols were created or gained traction after these tragedies, which is also a signal of how young the crypto market is. These events are what make the market develop and consolidate in the long term, it’s a natural thing.

Here are some instances where insurance would have been a lifesaver:

• Axie Infinity (Ronin Sidechain) - Loss of around $620 million

The first event here happened in March 2022, and the target was the blockchain game, Axie Infinity. The funds were drained from the bridge that connects the Ronin Sidechain (Network that supports Axie Infinity) to the Ethereum blockchain. The hackers stole around U$625 Million in wETH and USDC.

This event would be classified as Smart Contract coverage in an insurance application.

• Bitfinex Hack - Loss of around $70 million

This event was a hack on a very popular Hong Kong-based centralized exchange, Bitifinex. In 2016, hackers were able to steal around U$70 Million from the exchange. After the attack, the funds were tracked down and Bitifinex managed to refund their customers.

Although in this case clients were refunded, there were many other hacking occasions in history, most of the time in smaller exchanges, which sometimes are not able to pay back the funds to their clients. If you’re exposed to an exchange, consider looking at insurance to prevent yourself from the worse!

Conclusion

The insurance sector is still developing and conquering the market, but as we’ve seen in this article, it’s very important to know that you can protect your funds from events that are not usual, but have happened before and might happen again in the future.

Keep in mind, the cost of insurance (premiums) can vary based on the contract's perceived risk, evaluated by factors like the protocol size, type of insurance, timeline, among other minor factors.

Before diving into an investment strategy, weigh the risks and decide if insurance is worth it. Sometimes the cost may skew your risk/return ratio, making it less advantageous.

The future looks promising for blockchain insurance. It has the potential to replace many traditional insurance products. With blockchain, insurance contracts can be executed automatically, faster, and cheaper, with no third-party involvement.